In pursuit of low-risk income

A new year brings a new fixed-income outlook -- and a need for new strategies

BOSTON (MarketWatch) -- For many retirees and pre-retirees, it is the eternal quest: Which investments will produce the greatest amount of income with the least amount of risk?

In 2007, the answer was simple: Money-market funds and U.S. Treasurys. Now, however, experts are predicting the Federal Reserve will cut interest rates further in 2008 and retirees and pre-retirees -- at least those who plan to hold their investments for more than one year -- must turn over other rocks.

"We think the Fed will cut the federal funds rate by 0.75 percentage points in 2008 and even further in 2009," Mauro wrote in a just-published report. "If we are right, rates on money markets (which now yield about 4.5%) will decline."

That means investors will be hard-pressed to maintain the current income stream on those securities. "The key thing is for retirees to preserve income," he said.

So, what's the best way to preserve income, if not with money-market funds or U.S. Treasurys? According to Mauro, here are the key fixed-income themes that will emerge in 2008.

High-quality alternatives to Treasurys

Investors should focus on instruments that offer an appropriate yield pick-up over Treasurys, Mauro wrote. He said the flight to quality in 2007 pushed Treasury yields down substantially and now investors must look at high-quality alternatives. As of Jan. 9, the yield on the 10-year Treasury is 3.8%.

His favorite alternatives to Treasurys include municipal bonds, certificates of deposit, and preferred securities.

Investors, including those in the 25% federal tax bracket, looking at municipal bonds should consider those with maturities in the five- to 15-year range, which now are yielding anywhere from 3.6% to 4.5%. Those bonds will benefit the most if yields decline, he said.

Mauro also said the biggest worry about municipal bonds during 2007 will continue for at least the early part of 2008: The safety of the bond insurers. If, however, investors focus on municipal bonds that are rated "single-A," they should be O.K. Those bonds have a historical default rate of less than 1%, according to Mauro's report.

Of note, Mauro said municipal bonds are best suited for taxable accounts.

Investors who want to avoid interest-rate risk -- the risk of bond prices falling if interest rates rise -- should consider certificates of deposit. Right now, a five-year CD is yielding about 4.2%, according to Bankrate. Such investments would be appropriate for a tax-deferred account such as an IRA, he said.

Those who are slightly more risk-tolerant might take a look at preferred securities and mutual funds/ETFs that invest in preferred securities, Mauro said. These securities, 75% of which are issued by financial institutions, had a rough go in 2007. In fact, 2007 was the worst ever for preferreds. But 2008, though price risks still exist, could be different.

"We think that present yields are high enough to compensate for the near-term price risks," Mauro wrote. Recommendations include domestic, qualified dividend, income-paying, single A- or AA-rated issues. With prices down over the past few months, yields are 7.25%, or more than 8.5% on a taxable equivalent for someone in the 15% federal tax bracket.

For its part, Morningstar points to Davis Appreciation & Income
RPFCX, +0.11%
and Vanguard Convertible Securities
VCVSX, +0.55%
as its favorite convertible funds, the type of fund that largely invested in preferred securities.

Look to TIPS

TIPS can be an inexpensive inflation hedge. Thanks to a fairly high inflation rate and decline in real interest rates, TIPS were the best performer in the bond world in 2007.

"But the breakeven inflation rate for 10-year maturities remains low at 2.3%," Mauro wrote. "If inflation is higher than that over the next 10 years, TIPS will do better than nominal Treasurys."

When looking at individual TIPS, Mauro suggests focusing on individual TIPS that mature in five to 10 years. Morningstar lists Vanguard Inflation-Protected Securities
VIPSX, -0.15%
and Harbor Real Return
HARRX, -0.21%
as its favorite inflation-protected securities bond funds. The current yield on the Vanguard fund is 1.4%, though that doesn't include any income adjustments due to changes in the inflation rate. As with other fixed-income investments, these securities should be placed in a tax-deferred account.

Look abroad

Foreign bonds have done well for U.S. investors in recent years due in large part to the dollar's depreciation. Now, according to Mauro, the dollar may be near a bottom and that means coupon income and price appreciation may rule the day in 2008.

Investors will take on currency risk by investing in foreign bonds and they should focus on specific countries when investing in such bonds. For instance, he suggests avoiding Japanese bonds, which yield 1.5%, and considering instead "Eurozone" bonds, which yield 5%. "Performance will vary by country," he said, at least among emerging markets bonds.

Closed-end funds

Consider selective forays into closed-end funds (CEFs). Mauro recommends municipal and preferred CEFs, some of which are selling at a 5% discount, for more risk-tolerant investors. To be sure, the factors that have held prices down in 2007 will not go away immediately in 2008, Mauro wrote. So investors should be somewhat selective about which CEFs, avoiding senior loan funds, for instance.

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